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Guest Post: Negative Interest Rates – The Real Game

Note: This is a guest post by Devendra Nevgi who runs Delta Global Partners. Disclosure: Deven advises Learning Infinite who advertise at Capital Mind.

As the world gets engulfed by the European (EU) sovereign crisis and the feeble recovery in USA (weaker jobs data), the largest beneficiaries have been the investors in sovereign bonds issued by relatively stronger and stable economies. Safe haven demand for bonds issued by Germany, Switzerland and USA (being global reserve currency despite weak macros) have witnessed steep rise in price leading to rapid fall in yields. The 30 year US Treasury bonds have returned 9.3% only in the month of May 2012. This is in addition to 35% return in the year 2011. The universe of assets with “risk free or pure AAA status” has shrunk at an accelerated rate since the Lehman & the EU crisis. Return of capital is now more important than the return on capital as risk appetite waned and “Fear overtook Greed”.

The “Fear Demand” was so overwhelming that it took the yields on sovereign bonds of safer countries like Germany and Switzerland to near or below zero (negative). Germany in last month issued 2 year -EUR 5 bn worth par bonds at a coupon rate of “Zero”. With the inflation rate (CPI) in Germany at around 2% (year on year), the buyers of the bond holders are losing money (real return are negative) or in other words investors are paying interest to hold these bonds. Is this rational or is it a bubble?

Chart I: German Bonds 2 year Yield- Near Zero & lower

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Source: Bloomberg

Similarly the Swiss 2 year bonds are already trading at yield of -0.28%, which were trading at 0.82% in as early as April 2011. And the inflation (CPI-yoy) is around -1%. Swiss Franc being the “Numero Uno” in the list of safe haven is attracting flows like bees to honey.

Chart II: Swiss Bonds 2 year Yield- Negative

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Source: Bloomberg

Now the question that comes up is instead of buying bonds at negative real yields –“Why do investors don’t hold the currency itself under the mattress or in the bank? Well- we do understand that European banks are no longer safe and no wonder in recent times there has been a run on Greece & Spanish bank deposits. And under the mattress is not exactly a viable proposition, since the scalability remains low and security risk remains higher.

Probably the reason the smart foreign money is pouring into German bonds is the fact the bonds are insurance or a hedge against an EU break up. The break up would ensure that German bonds are replaced with new Deustche Mark (DM) denominated bonds. The DM after the break up would rapidly appreciate being the strongest economy in the EU. Investors may also be switching out of Italian and Spanish bonds (which are at mercy of ECB or the “troika”) to German bonds. So effectively a bit of negative yield is acceptable vis a vis the potential of a larger currency gain. Risk and Reward balance is heavily tilted towards outsized Reward and almost no risk.

Chart III: Pegging the Swiss Franc v/s Euro till last breath

image Source: Bloomberg

As we all are aware that the Swiss currency- the Swiss Franc (CHF) is the currency to which one runs for cover from all kind of global financial or political risks as a “safe haven”. And this is evident from the steep appreciation of the CHF vis a vis Euro since the time the EU crisis raised its ugly head for the first time in late 2009 (Chart III). The Swiss Central Bank (SNB) valiantly fought the appreciation by buying (interventions) various currencies mainly the EUR’s – in turn boosting its foreign currency reserves to a record of USD 316 bn equivalent (Chart IV). As the interventions failed to stem the appreciation- SNB on a valuation basis lost good amount of money. For the year 2010 the SNB reported a loss of CHF 19.2 bn and in 2011 it was turnaround when it reported a profit of CHF 13.5 bn. Finally in September 2011, SNB pegged set a floor to the EUR-CHF rate at 1.20 and were willing to buy unlimited amount of foreign currency- as the appreciating CHF had started to hurt the country’s economic growth, which thrived on inter alia on exports.

The reserves accretion has fallen recently indicating the SNB may have scaled back its intervention- as EURO itself fell due to the rising risks of Greece Exit and Spanish banks. This conclusion of lack of intervention may be a little hazy (lack of transparency) as SNB could have intervened in the forward markets through currency swaps thus ensuring a negative carry- which does not normally affect the foreign exchange reserves. Intervention can take place in many indirect ways.

Coming back to Swiss Bonds – buyers at negative yields probably are betting on a breakdown of the EURCHF peg by SNB, which will allow the CHF to appreciate swiftly ( SNB will further lose money) to a level which is commensurate with the massive safe haven demand pull. This will help the foreign bondholders to make more money. So again negative yields don’t matter vis a vis the expected onetime adjustment in the currency especially when the central bank is expected to lose its grip on it. The 2 year Japanese bond yields are also low at 0.1%, but it does attract foreign buyers as Japanese Yen is also one of the safe havens. But the Japanese Central Bank has the tendency to stem any rapid appreciation of the Yen.

Chart IV: Swiss Central Banks FX Reserves

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Source: Swiss National Bank

To conclude, the negative yields on safe haven bonds may not appeal to a rational fixed income investor, but the game is a little different than plain vanilla yield to maturity on these bonds.

Post Author: Devendra Nevgi

Deven has 17 years of diversified experience in managing Debt and  other portfolios in  domestic and global markets. He runs Delta Global Partners from India and Singapore, which provides India dedicated research to international clients. He is the program advisor for the Advanced Debt Portfolio Management Program with Learning Infinite.